China’s first bank loan contraction in nearly two decades has fanned fears the world’s No 2 economy is careening towards a “balance sheet recession” as Japan did decades ago.

A plunge in new corporate borrowing combined with households preferring to repay debt saw bank loans shrink last month for the first time since July 2005. That deepened China’s years-long battle with weak credit demand, as a property slump spurs caution on buying homes or expanding investment. 

Determination among consumers and businesses to pay down debt following real estate collapse is seen as a hallmark of Japan’s stumble into decades of deflation in the 1990s. 

Economists have long debated whether China is facing a similar “balance-sheet recession”, a concept Richard Koo, the chief economist of Nomura Research, used to explain Japan’s “lost years”. His theory is families and businesses, spooked by falling asset prices in Japan, focused on clearing debts and stopped spending in the economy.

While China’s current situation has clear differences to Japan’s predicament, following in its Asian neighbour’s footsteps remains a risk, said Lynn Song, the chief economist for Greater China for ING Bank in Hong Kong.

“We already see some worrying signs of widespread pessimism setting in,” he said. “It remains of vital importance to stabilise asset prices before this sort of mindset becomes too entrenched.”

Other economic indicators are also pointing to a deterioration in domestic demand that has dragged on the economy this year, and put President Xi Jinping’s annual growth target of about 5% under pressure.

Core inflation, which strips out volatile food and energy costs, rose just 0.4% in July, the least since January. That came after economy-wide prices declined for five straight quarters, in the longest slide since 1999.

China’s steel industry is now facing a crisis more serious than the downturns of 2008 and 2015, the world’s biggest producer warned in a statement, as the property downturn and weaker factory activity push prices to multi-year lows.

Data due Thursday is expected to show retail sales remained sluggish, despite a slight improvement thanks to a more favourable base of comparison and the summer holiday season. A key gauge of Chinese services activity that covers the retail industry was on the brink of contraction for the first time since last year in July.

China’s bond markets are reflecting concerns the country faces a period of stagnation, subdued inflation and low interest rates. Yields have fallen to record lows across the curve and corporate bond spreads have narrowed as investors flocked to fixed income in favour of stocks, despite pushback from Chinese authorities.

Japan’s government bond yields were depressed for an extended period of time during its “lost decades”.

The People’s Bank of China has intervened repeatedly with verbal warnings and regulatory action in the government bond market in recent weeks. Policymakers are concerns about a negative feedback loop between falling yields and weakening expectations for the economy.

Ren Zeping, a well-known analyst who previously served as the chief economist of China Evergrande, said China’s situation had “similarities with Japan’s balance-sheet recession in the 1990s”. High households savings, weak loan demand, low consumer and asset prices as well as high real borrowing costs all had parallels, he wrote in a Wednesday note.

Despite those commonalities, economists have pointed to some differences that suggest China may not sleepwalk into Japan-style stagnation anytime soon. 

For one, the debt-to-gross domestic product ratio for the household sector has largely flat-lined since the Covid-19 pandemic, while that debt level for the corporate sector - which includes state-owned enterprises that are less sensitive to demand shifts - has kept rising. 

China’s real estate price collapse has also been less severe than what was seen in Japan during its prolonged crisis in the 1990s. 

The Plaza Accord, signed by major economies in 1985 to weaken the US dollar, caused the yen to appreciate and shattered Japan’s export competitiveness. That shock also contributed to Japan’s lost decade, said ING’s Song, who noted that China’s foreign exchange policy is more flexible.

To determine a balance sheet recession, “we need to at least see that companies are deleveraging”, said Larry Hu, the head of China economics at Macquarie Group Ltd, noting another distinction. “There isn’t a significant contraction in liabilities.” 

  - Bloomberg